What’s a leveraged ETF and what makes it dangerous?

Larry Fink is sounding the alarm. The chairman and CEO of $4.4 trillion asset manager BlackRock is worried about leveraged ETFs (exchange-traded funds). Fink thinks they could “blow up the industry.” His statement is a little unclear, but the industry he’s referring to is probably ETFs themselves, not the global financial system.

Blackrock is itself a huge player in ETFs, but Fink says they’ll never get into leveraged version of the financial instruments.

So, what’s the difference between regular and leveraged ETFs?

Regular ETFs are designed to track the price of a specific set of securities, taking the place of traditional mutual funds that focuses on particular investment sectors or classes of stock. ETFs started in stocks, particularly indexes, but now cover all types of assets. In this way they are similar to a mutual or index fund, but can be bought or sold like a stock. Regular ETFs, particularly the ones that track broad indexes like the S&P 500, are pretty vanilla financial products. Sure, an index fund might be slightly better for achieving individual investment objectives, but ETFs generally have much lower fees than actively managed mutual funds.

Leveraged ETFs take the idea a step further. They are designed to amplify, not mimic, the price changes of the assets they track. If oil goes up $1, an oil ETF should go up $1. If oil goes up $1, a three times levered oil ETF will go up $3. The way that works is that levered ETFs are based on derivatives.

Fink is worried that regular ETFs’ growing good name will lure people who shouldn’t own derivatives into derivatives ownership, without even realizing it. At its core, Fink’s concern is about retail investor access to derivatives products that are not suitable for them. This is a legitimate concern.

Selling investors who want long-term index-like investments a pocketful of derivatives exposure is wrong. As Breakingviews put it (paywall), “that’s akin to giving a circular saw to a toddler. These short-term, structured ETFs can make mincemeat of an unwitting buyer’s investment portfolio.”

And when that happens, there are existing regulations to punish unscrupulous brokers. The open question, as with much of financial regulation, is how or if those regulations are actually enforced.

For now, levered ETFs make up just 2 percent of the $1.7 trillion global ETF market. But there are other types of ETFs that might be unsuitable for individual investors, as well. For instance, should you have a basket of concentrated tech stocks in your retirement fund? Levered or not, the answer is no. Broadly, there are about 20 percent less derivatives outstanding than there where before the financial crisis. But if markets become suddenly volatile, it is not really clear how ETFs, levered or otherwise, will behave as they move through the clearing and settlement infrastructure on the financial system. It is this uncertainty that has led the Bank for International Settlements, the Financial Security Board, and the International Monetary Fund to call ETFs a systemic risk (paywall) to the financial system.